A Closer Look at Hedge Fund Risk: Two New Studies by François-Éric Racicot

Professor François-Éric Racicot has made another strong contribution to a more nuanced understanding of hedge fund risk. A specialist in financial econometrics, Racicot has built on the prior literature to propose a new hedge fund return model that accounts for the new dynamics of financial markets and the cyclical behaviours of hedge funds.

Hedge fund risks have been implicated in the financial vulnerability that made the global financial crisis possible. A central focus in these investment vehicles is the use of aggressive trading strategies to optimize returns, including high leverage and borrow techniques to increase the amount of money available to risk. One estimate puts the value of the international hedge fund market at $2 trillion and it continues to grow.

One of the responses of researchers has been to confront the drawbacks inherent in conventional hedge fund return estimators and to propose improved methods. Racicot and Raymond Théoret of the Department of Finance, UQAM demonstrate that their hedge fund return model performs well empirically, and they also propose a new procedure for capturing measurement errors in asset pricing models. The researchers published their study in February 2014 in the journal Applied Economics and it is already being cited in graduate finance courses (including an intermediate-level Ph.D. course in applied econometrics at the Stern School of Business, New York University). In mid-2013, the team also published a study in the Journal of Journal of Derivatives & Hedge Funds which is considered to be one of the first to examine in detail the cyclical profile of hedge fund returns. The research demonstrated the value of further study of hedge fund return models in dynamic settings.

Hedge funds are a key element of the “shadow banking” system that in recent years has grown into one of the pillars of the financial system. However, the risk taking of a major hedge fund has the potential to create aggregate shocks that ripple throughout the financial system. Moreover, pension funds savings are increasingly invested in hedge funds in response to the downward trend seen in conventional savings vehicles. The implications of Racicot’s ongoing research on hedge fund return models are therefore attracting interest well beyond academia.

Associate professor of finance at the Telfer School, Racicot teaches finance and applied econometrics. He has published several graduate-level texts in quantitative finance and financial econometrics and is a member of the editorial board of several highly-regarded journals. He is an advisory board member of the financial journal: AESTIMATIO-The IEB International Journal of Finance. He contributes to the CGA-Canada Accounting and Governance Research Centre at the University of Ottawa. He is also a research associate at the Corporate Reporting Chair at l'Université du Québec à Montréal (UQAM).

Articles cited:

"Cumulant Instrument Estimators for Hedge Fund Return Models with Errors in Variables", Applied Economics, 2014, Vol. 46, No. 10, 1134-1149.

"The Procyclicality of Hedge Fund Alpha and Beta", Journal of Derivatives & Hedge Funds, Vol. 19, 2, 109-128.